QE II: Is Fed about to crown a new U.S. monetary policy?

Thursday

Oct 28, 2010 at 12:01 AM

Ernest 'Doc' Werlin

"In a world in which the policy interest rate is close to zero, the (Federal Reserve) must consider the costs and risks associated with the use of non-conventional tools when it assesses whether additional policy accommodation is likely to be beneficial on net."

–Federal Reserve Chairman

Ben Bernanke, Oct. 15

Boston Federal Reserve

In the context of recent discussions about U.S. economic policy, QE II does not stand for Queen Elizabeth II. Instead, it represents a novel monetary experiment the Federal Reserve is expected to unleash. In what will be the firing of the last arrow in its quiver, the Fed will implement a second round of quantitative easing (QE II).

QE I, which included guarantees of trillions of dollars of obligations and the reduction of the discount rate to almost zero, stabilized the American economy when it was threatening to melt down in 2007, but it did not ensure a robust recovery.

The term "quantitative" refers to creation of money. "Easing" refers to adding bank reserves -- the money banks use to conduct their daily business.

QE 2 would seek to:

Double the inflation rate to around 2 percent.

Decrease unemployment to approximately 5 percent.

Bump up our weak housing market.

In QE 2, the Fed is expected to increase the supply of money by purchasing up to $3 trillion in Treasury obligations over the next six months.

To accomplish this, the Fed would first make a bookkeeping entry that adds reserves electronically to its account. Adding reserves achieves comparable results to printing money. Second, the Fed would purchase financial assets such as government bonds and mortgage-backed securities in order to increase the excess reserves of U.S. commercial banks that are Federal Reserve members.

More reserves would encourage the banks to make additional loans. Loan proceeds increase aggregate demand because business recipients can make new investments in their plants and equipment and in hiring more workers. More workers mean greater consumption.

An ancillary benefit of QE II could be the increase in values of fixed assets, including home prices. The "wealth effect" (the psychological benefit of increasing asset prices) could raise consumption and therefore demand.

Could stimulate the same type of hyperinflation that afflicted Germany after World War I.

Could raise such strong doubts about the integrity of the currency that people would shun it for hard assets such as gold or real estate.

Could further reduce U.S. interest rates and thereby weaken the dollar. A weak dollar would make foreign goods more expensive, reduce imports and disrupt global trade.

Or, alternatively, it could be a dud if our banks emulated the Japanese banking practices of the early 2000s. Japanese banks decided to sit on their additional cash reserves rather than make incremental loans to boost their economy.

Mickey Levy, chief economist at Bank of America, said in an October speech at the Boston Federal Reserve that, "The Fed is trying to achieve too much. They want to stimulate demand, but there are a lot of nonmonetary factors that are inhibiting the economy, including distressed mortgages and foreclosures, the need for households to save, and a whole Federal Reserve Bank of Kansas City President Thomas Hoenig said at the same conference, "Without clear terms and goals, QE II becomes an open-ended commitment that leads to maintaining the funds rate too low and the Federal Reserve's balance sheet too large."

Bernanke understands that in implementing QE II, the Fed would be operating on the edge of a precipice. It might even betray classical economic principles. In his speech at the Boston Federal Reserve, Bernanke cautioned that "unconventional policies have costs and limitations that must be taken into account in judging whether and how aggressively they should be used."

Despite the misgivings of Bernanke and others, most Fed watchers believe that the Fed will begin implementing QE II at its meeting Wednesday in an attempt to stop our downward spiral in economic demand.

Ernest "Doc" Werlin is a local columnist who welcomes suggestions and comments at doc.werlin@gmail.com.

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